TY  - JOUR
AU  - Parrado,Eric
AU  - Velasco,Andres
TI  - Optimal Interest Rate Policy in a Small Open Economy
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 8721
PY  - 2002
Y2  - January 2002
UR  - http://www.nber.org/papers/w8721
L1  - http://www.nber.org/papers/w8721.pdf
N1  - Author contact info:
Eric Parrado
Department of Economics
New York University
19 W. 4th Street, 6th Floor
New York, NY 10012

Andres Velasco
Columbia University
School of International and Public Affairs
420 West 118th Street
New York, NY 10027
Tel: 212/854-3899
E-Mail: avbranes@gmail.com
AB  - Using an optimizing model we derive the optimal monetary and exchange rate policy for a small stochastic open economy with imperfect competition and short run price rigidity. The optimal monetary policy has an exact closed-form solution and is obtained using the utility function of the representative home agent as welfare criterion. The optimal policy depends on the source of stochastic disturbances affecting the economy, much as in the literature pioneered by Poole (1970). Optimal monetary policy reacts to domestic and foreign disturbances. If the intertemporal elasticity of substitution in consumption is less than one, as is likely to be the case empirically, the optimal exchange rate policy implies a dirty float: interest rate shocks from abroad are met partially by adjusting home interest rates, and partially by allowing the exchange rate to move. This optimal pattern may help rationalize the observed fear of floating.
ER  -